Russia's Virtual Economy / Edition 1

by Clifford G. Gaddy, Barry W. Ickes

Overview

"Clifford Gaddy's and Barry Ickes' paradigm of the "virtual economy" has fundamentally changed the way people think about Russia's economy. Circulated at the highest levels of the Russian and U.S. governments and reported in leading publications worldwide, their thesis—that Russia's economy is based on illusion or pretense about nearly every important economic yardstick, including prices, sales, wages and budgets—has forced broad recognition of the inadequacies of the intended market reform policies in Russia. More important, their work has provided a coherent framework for understanding how and why so much of Russia's economy has resisted reform. Gaddy and Ickes now use the virtual economy concept to project the near- and middle-term future of the Russian economy and suggest possible policy responses. Drawing on new empirical material from published and unpublished sources and from their own extensive field work in Russia, the authors examine critical aspects of the virtual economy: manufacturing enterprises, households and the public sectors, both local and federal. For the first time, they will also integrate the financial and agricultural sectors into their model. Gaddy's and Ickes' book can be expected to be a seminal work for understanding the inner workings of the Russian economy. Clifford G. Gaddy is a fellow in Foreign Policy Studies at the Brookings Institution and a member of Brookings' Center on Social and Economic Dynamics. He is the author of The Price of the Past: Russia's Struggle with the Legacy of a Militarized Economy (Brookings, 1996) and coauthor of Open for Business: Russia's Return to the Global Economy(Brookings, 1992). Barry W. Ickes is associate professor of economics at Pennsylvania State University and director of research at the New Economic School, Moscow.

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Product Details

ISBN-13:	9780815731115
Publisher:	Rowman & Littlefield Publishers, Inc.
Publication date:	07/01/2002
Edition description:	New Edition
Pages:	322
Product dimensions:	6.02(w) x 9.08(h) x 0.84(d)

About the Author

Clifford G. Gaddy is a senior fellow in the Foreign Policy and Global Economy and Development programs at Brookings. Barry W. Ickes is professor of economics at Pennsylvania State University.

Read an Excerpt

Russia's Virtual Economy

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By Clifford Gaddy and Barry W. Ickes

Brookings Institution Press

Copyright © 1999 Brookings Institution Press
All right reserved.
ISBN: 0815731124

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Chapter One

Introduction

"We hoped for the best, but it turned out as usual."

-Viktor Chernomyrdin

Economic reform in Russia has been anything but the smooth process envisioned by many in 1991. The general problem of reform seemed straightforward. The essential task was to remove the distortions created by central planning. Once the restrictions on economic behavior were lifted, the market would develop. Of course, it was recognized that there would be bumps along the way, but these would not distract from the task at hand. The main requisite was the will. Transition would be like turning a great ship in a choppy sea: set a course designated "market economy" and hold on. There might be great tossing and turning, but if the captain and crew could hold the course, the ship would eventually reach its destination.

In practice, the Russian transition has turned out to be vastly more complicated -so much more so that a better image might be that of replacing the propeller engines of a passenger airplane with jet engines ... during flight. Attempting this is not only complex and unprecedented; it is highly likely that the airframe may be completely unsuited to the new engines. As time passes, the passengers worry less and less aboutthe unpredictable turns and sudden changes in elevation. They forget about how soon, or even whether, they will reach the planned destination. Rather, their overriding concern becomes the sheer struggle to stay aloft-survival.

Regardless of the metaphor one chooses, the difficulties that Russia has encountered in the transition have posed an interesting set of problems for analysts. Trying to understand the reasons for these difficulties has become a growth industry among observers of the Russian economy. Most analyses of what went wrong fall into one of two camps:

-Technocratic: The wrong policies were adopted, embodying either too much or too little therapy.

-"Russia is different": Russia's unique culture and history ensured that the policies promoted by market reformers would not work.

These arguments share the premise that the choice of policies made the reform path so arduous. Of course there is a great difference between camps over what the bad choices were. In the technocratic view the problem is that the wrong policy settings were chosen for transition to the market economy. In the "Russia is different" view the problem is that the chosen path was inconsistent with Russian history and culture. It is, of course, tempting to focus on bad choices because it makes blame easier to assign and because it makes the difficulties of transition seem potentially avoidable. It is not clear, however, that succumbing to this temptation enhances understanding.

Our approach to the problem of Russian transition is different. We focus on the inherent difficulties of the process stemming from the economic structure bequeathed by central planning. We would not argue that no mistakes were made along the way. However, we do not believe that the principal causes of the rocky road were remediable policy errors. Instead, we emphasize the inherited problems, primarily a vast industrial structure that could not compete in a market setting. This heavy industry sector, where the bulk of industrial employment still is located, has been the most resistant to reform; and it is the continued presence of this sector that most negatively affects Russia's growth prospects. Had it been possible to quarantine this sector of the economy and let it decline slowly, the transition might have been different. In the absence of such insulation, however, what happens to this sector affects the whole economy and politics. In particular, when this industrial structure was shocked by the sudden collapse of central planning, economic agents adapted their behavior to survive in the new setting. Optimists had assumed that agents would adapt their behavior in a manner consistent with a market economy. In fact, they adapted their behavior in a different manner, to a mode consistent with what we call the virtual economy. Explaining this process and what it means for economic development in Russia is the purpose of this book.

Our goal is to provide a method of analysis-a model that can be used to think about transition in Russia. We believe that without such a model it is not only difficult to understand developments in Russia, but is even harder to think about how Russia can escape the virtual economy trap.

Some readers may ask, Why is this relevant now? In the year 2000, Russia's gross domestic product (GDP) grew 9 percent. Although the growth rate slowed to 5 percent in 2001, it still represents a great improvement over the first seven years of transition. Barter is down, and Russia is repaying its debts to the International Monetary Fund at an accelerated pace. Perhaps, one might argue, the problems that we are concerned with are in the past now. Perhaps Russia has finally achieved the critical steps that make growth self-sustaining.

Although there are some positive signs of change in Russia, as always it is best to think about Russia as an iceberg: it is what is below the surface that must be watched carefully. Consider then figure 1-1, which shows the percentage of loss-making industrial enterprises in Russia during transition. What is remarkable about this picture is that despite the real depreciation of the ruble and high oil prices, the share of loss makers continues to be exceptionally large, nearly 40 percent. There was a one-time improvement after the August 1998 crisis, but subsequently the share remained stable.

What this suggests is that there continues to be a large core of enterprises that survive despite their performance rather than because of it. The future for this core cannot be ignored in thinking about how Russia will develop. When the dinosaurs became extinct, niches were opened for mammals to develop and thrive; bit players in the previous era evolved into the dominant forms of life. In Russia, however, the dinosaurs-this large industrial core-survive, and as long as they do, they inhibit economic progress. Because of their sheer size and their importance for employment, these enterprises have a political and social significance far in excess of their economic importance. The virtual economy thus remains relevant.

What Is the Virtual Economy?

Many understand the virtual economy to be synonymous with the phenomenon of widespread barter, other nonmonetary transactions, and taxes paid in kind. This is not how we have used the term, however, for this confuses a symptom with the disease. The lack of restructuring in the Russian economy is the fundamental problem that the virtual economy model addresses. It is rather easy to understand why there may be forces that do not want to change. We do not need a complex argument to understand why economic transition may threaten the position of certain elements in society. The difficult part is to understand how these agents can succeed at blocking changes that have large economic advantages. The most threatened agents, after all, are those who work in or direct enterprises that are value destroying: the loss-making dinosaurs, the most prominent legacy of the Soviet period. The point of introducing markets is precisely to create the pressure on these enterprises to reform or die. During the first decade of economic reform in Russia, privatization was carried out on a massive scale, and overt subsidies to enterprises were reduced practically to the point of elimination. How enterprises could survive in this environment without restructuring thus presents a serious puzzle.

The virtual economy is the outcome of agents' adapting their behavior to an environment that threatens their survival. It is characterized by a set of informal institutions that permits the production and exchange of goods that are value subtracting, that is, worth less than the value of the inputs used to produce them. Enterprises can continue such production because they have recipients who are willing to accept fictitious ("virtual") pricing of the goods at levels that mask their unprofitability. Buyers and sellers collude to hide the fictitious nature of the pricing (that is, the discrepancy between the virtual prices and the true, market, prices). In the classic form of the virtual economy, they do so by avoiding money: they use barter and other forms of nonmonetary exchange, as well as even more intricate subterfuges. Since value is being destroyed as the system operates, there also has to be a source of value infusion. The ultimate "value pump" in Russia today is the fuel and energy sector, above all one single company, Gazprom-Russia's natural gas monopoly. In exchange for the rights to keep what it earns from exports, Gazprom pumps value into the system by supplying gas without being paid for it (or, more generally, at a cost that is low enough to keep enterprises operating). Gazprom subsidies-which then lead to arrears to the government-are the primary way in which unprofitable activity is supported today in Russia.

The system survives because it meets the needs of so many actors in the economy. Workers and managers at industrial dinosaurs benefit because the virtual economy postpones the ultimate reckoning for loss-making firms. Government, especially at the subnational level, where much of the important action takes place, benefits because it maintains employment and continues providing social services. Gazprom also benefits, however; the value transfers it makes to the virtual economy are the price it pays to be able to appropriate the massive rents from exports. One side of the transaction for Gazprom is the value that must be pumped into the economy; the other side is the value that leaks out.

This is not to argue that people would not be better off if the virtual economy were replaced by a functioning market economy. There are great inefficiencies in the virtual economy. It is a clear impediment to growth and development. The key point is that the equilibrium is stable; it does not pay for any actors to depart from the behaviors that characterize it. This is surely the most pernicious effect of the virtual economy-those who try to play by the normal market rules are penalized relative to those who play by the virtual economy's rules.

This brief description identifies several of the key themes that recur throughout this book and that distinguish our view of Russia's economy from most others. These interconnected and interdependent themes include (1) an emphasis on the initial conditions that Russia faced as it began its transition; (2) the impermissible nature of the consequences of serious reform policies; (3) behavioral adaptation by agents in the economy; and (4) the extent to which so many agents in the economy participate in what we refer to as "the loot chain."

Initial Conditions

Acknowledging the importance of Russia's initial conditions goes farther than the simple realization that Russia's starting point for market reform was bad. It also requires knowing what those initial conditions were and how they helped shape the subsequent behavior of agents. The first basic fact is that restructuring was not a realistic prospect for a great many Russian enterprises: they began the transition too far away from viability. Of course, a sufficient infusion of outside resources can guarantee successful restructuring for any enterprise, because this makes it possible to reconstruct the entire enterprise from scratch. Therefore, any meaningful notion of restructuring has to consider the opportunity cost of making a given enterprise viable. For most Russian enterprises, the cost of reaching viability was prohibitive. This pandemic condition was hidden from view by the nature of Soviet pricing. Indeed, the transfer of value from the raw materials sector to manufacturing was a critical feature of the Soviet economy. This transfer of value through Soviet pricing hid the true features of the Soviet economy. In effect, Soviet pricing was like a distorting mirror at the carnival. The reflection distorted the relative importance of sectors in arbitrary but systematic ways. The illusion that these enterprises were value producing, when in fact they were value destroying, was one key initial condition of the transition.

A second basic fact was the social importance of the nonviable enterprises. This is also a legacy of the Soviet system. Enterprises were more than just productive units; they were also the major providers of social services. The industrial "dinosaurs" established under the dictates of communist central planning still employ millions of people and support entire cities and regions across the country. Because of the social importance of these enterprises, their viability cannot be assessed solely in terms of their physical capital. Enterprises and their directors accumulate relational capital (see chapter 3) to influence the behavior of officials whose actions can affect their survival. Our analysis of enterprise behavior focuses on the interaction of physical, human, and relational capital.

The third basic fact is the degree to which value-adding activity in Russia is concentrated in the resource sectors. The Russian economy, like the Soviet economy from which it is descended, is and has been primarily an economy driven by resource industries. Although the Soviet economy produced missiles, cars, planes, and space stations, the bulk of value added was produced in the energy and other raw materials and basic commodities sectors. Little has changed today.

These initial conditions may seem self-evident to any student of the Russian economy. It is thus all the more remarkable that these conditions are ignored in most of the technical debates about Russian reform. Most debates on reform focus on the speed and comprehensiveness of measures or on the sequence in which reforms must be carried out. Those debates may differ over diagnosis of where reform has gone wrong, but they share a common methodology. The focus is on the intended goal of market reform, not the initial conditions in which this transition is to take place. The debates thus produce a laundry list of needed reforms, all of which are sensible, but no framework within which to understand their interaction and, more important, no way to understand why the economic system rejects these interventions.

Impermissibility

A second key notion underlying our approach comes from the observation that while policymakers-the reformers-in Russia adopted one conventional measure after another in their attempt to transform Russia into a market economy, very few of those measures were ever fully implemented, and the intended effects were rarely achieved. Incomplete implementation and policy reversal have been the norms in the Russian transition. To understand why, we focus on the role of initial conditions and behavioral adaptation, rather than on exogenous political forces alone. This is facilitated by the notion of an "impermissibility constraint," which refers to restrictions on the set of feasible policies that arise from the prevailing values and norms of society.

When policy measures violate the impermissibility constraint, modifications in the implementation prevent them from having their full and intended consequences. These modifications arise precisely because the consequences of complete and proper implementation are politically intolerable. Russia did not formally reject the policies themselves; instead, it continued with a pretense of market reform. The nation's leadership proclaimed reform policies, while enterprises and other agents continued to behave in ways that rendered the policies ineffective.

Our mode of analysis is to incorporate political factors as constraints and then analyze how economic behavior and equilibria are affected. Considering the impact of political constraints on the reform process does not, by itself, represent a significant departure from previous analyses. But unlike previous studies we do not treat political constraints as exogenous. We root them in the inherited legacy of the Soviet economy. They arise precisely from the specific problems of transforming the Soviet economy. And we study how agents can act to affect these constraints by investing in relational capital.

By treating political factors as impermissibility constraints, we are trying to study the interaction of economic policies with political constraints and to analyze how the economic outcomes arise from this interaction. The course of transition in Russia has followed its particular path precisely because impermissibility constraints have often been binding. Of course, the fact that these constraints have been binding does not mean that policymakers have always been cognizant of them. In fact, the failure to consider these constraints has often led to perverse, or unintended, outcomes of economic reforms.

(Continues...)

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Excerpted from Russia's Virtual Economy by Clifford Gaddy and Barry W. Ickes Copyright © 1999 by Brookings Institution Press
Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.

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Table of Contents

Chapter 1	Introduction	1
Chapter 2	Illusion versus Reality	13
Chapter 3	Roots of the Virtual Economy	45
Chapter 4	"Igor" in the Virtual Economy	69
Chapter 5	Evolution of the Virtual Economy	102
Chapter 6	A Simple Accounting Exercise	128
Chapter 7	Running Out of Value	145
Chapter 8	The Virtual State	171
Chapter 9	Mr. Putin's Dilemma	191
Chapter 10	What Is to Be Done?	218
Appendix A	An Example of Barter to Evade Taxes	243
Appendix B	Selected Data and Findings from the Karpov Commission Report	247
Appendix C	Further Comments on Value Destruction	251
Appendix D	The Director's Decision Problem	256
Appendix E	An Evolutionary Model	266
Appendix F	Regions in r-d Space	272
	References	281
	Index	289
	Figures
1-1.	Percentage of Loss-Making Industrial Enterprises, 1992-2001
2-1.	Monthly Inflation in Russia, February 1992-September 1997
2-2.	Russian Stock Market (RTS-1), September 1, 1995-August 8, 1997
2-3.	The Rising Role of Barter in Industrial Sales, 1992-97
2-4.	Output and Employment at the Tutayev Engine Plant, 1990-96
3-1.	Enterprises in r-d Space
4-1.	Relative Supply of Hard Goods
4-2.	Three Enterprises in r-d Space
4-3.	The Restructuring Boundary
5-1.	Monotonic Reform
6-1.	Interactions among the Four Sectors
7-1.	Gazprom Running Out of Value, 1997-2010
7-2.	Depreciation of Relational Capital

Editorial Reviews

"Russia's Virtual Economy is destined to become a classic in the field of post-Soviet studies...Throughout ten densely packed chapters, Gaddy and Ickes weave an elegant an subtle, but at the same time forceful, argument....Summarizing the contents of this complex albeit rich and rewarding book in any greater length than this would be doing it a disservice, though. Suffice it to say that it should be an obligatory future reference for everyone with even a passing interest in Russia" —Juan Carlos Boue, The Journal of Energy Literature, 2/1/2004

"[A] penetrating and thought-provoking book which no serious student of Russia's post-Communist economy can afford to neglect." —Peter Oppenheimer, Christ Church College, Oxford, The Slavonic and East European Review, 10/1/2003

"Gaddy and Ickes have succeeded in incorporating the 'heritage' of Soviet institutions into standard economic analysis. This makes their book one of the few economic books in which the real world is not written away." —Joop de Kort, Institute of East European Law and Russian Studies, Leiden University, Economic Systems, 1/1/2002

"For those interested in Russia or in Russi'a place in the global economy, Gaddy and Ickes provide a satisfying explanation of how decades of central Soviet planning continue to affect Russian enterprises and why average Russians are worse off even though economic indictators seem to show progress." —Michael J. Harrison, Associate Editor, InterMedia Survey Institute, INCORE, 8/1/2005

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